More Failure Needed in 2009? January 1, 2009

Needed in 2009: More Failure?

In his new autobiography, 1,000 Dollars and an Idea, entrepreneur Sam Wyly praises the privations of failure. As a child, his family fell into poverty when his father’s grocery store went bust. The experience “taught me at an early age that failure forces you on to another path,” Wyly writes. “You have to go in search of new opportunities.” His father found new opportunities, selling insurance and running a newspaper. And Wyly became a billionaire building a string of companies including Bonanza Steakhouse, Sterling Software, and Michael’s Arts and Crafts.

Lots of entrepreneurs succeed on account of failure. Sometimes it’s their own failure, which teaches invaluable lessons. Sometimes it’s the failure of others, which creates new opportunities. Quite often, it’s both.

But Bailout Nation doesn’t believe in failure so much anymore. Over the past year, the government has rescued reckless banks, uncompetitive automakers, and a freewheeling insurance company that made billions’ worth of risky bets and lost. There’s still a huge federal fund of $350 billion ready to prevent more failures in 2009. And the one prominent instance where the government stepped aside and let the free market work—the collapse of Lehman Brothers in September—is widely, and perhaps wrongly, viewed as a mistake.

OK, so maybe all those bailouts have collectively served the national interest, by preventing a panic and dampening the effects of a nasty recession. But at some point—which we might have passed already—preventing failure does more harm than good. Here’s why we should be more tolerant of failure in 2009:

Bailouts perpetuate the problem instead of solving it. We’re probably about to learn that bailouts are an open-ended—and extremely expensive—proposition. AIG and Citigroup have both asked for one infusion of federal money, then another. Are they done? Or will they come back for even more? The $15 billion in federal loans for General Motors and Chrysler is almost certainly just a down payment on a bailout that could easily total $75 billion or more. And there’s no evidence at all that it will compel more people to buy their cars, which is the real problem. In the end, we might still be stuck with too many automakers building too many uncompetitive products.

There will also be significant unintended consequences of unprecedented government intervention in the financial system. One problem, for example, has been institutions considered “too big to fail,” which leaves the government with little choice but to intervene, to prevent catastrophe. But government-brokered consolidation has now made some of those banks and other firms even bigger. “If these organizations were too big to fail before, what are they now?” asks economist James Barth of the Milken Institute. Heck of a question.

Failure makes room for innovation. The history of capitalism is filled with instances where failure, sometimes on a grand scale, paved the way for progress. Mechanization in the 1800s displaced millions of workers but set the stage for some of the most remarkable technological advances in history. The birth of the automobile killed the horse and buggy and marginalized railroads but gave Americans unprecedented mobility. The Internet has wreaked havoc in the travel, music, and media industries yet introduced us to Facebook, YouTube, and a communications revolution. “With each wave of innovation, there’s a corresponding wave of failure,” says financial historian James Grant, publisher of Grant‘s Interest Rate Observer.

With numerous Wall Street firms failing their customers, this might be a moment of incubation for a wave of financial innovation. But will it flourish or die if the government props up behemoths like Citigroup with the ability to soak up capital and quash small competitors? And what automotive start-up will wither with GM and Chrysler blocking out the sun? The catch is, we may never know what doesn’t happen while business as usual goes on. “What’s important is the concept of opportunity cost,” says Grant. “What you stifle is what you can’t see.”

Failure makes everybody better. There are examples of this in practically every industry, because the threat of failure forces competitors to improve quality, lower price, and make sure they offer what consumers want. Wal-Mart has forced other retailers to be extremely efficient, because if they’re not they’ll go out of business. Toyota and Honda have helped raise the reliability of cars produced by everybody. Nike and Reebok became huge successes because the established shoemakers in the 1970s, Converse and Keds, were complacent and failed to respond as consumers took up jogging and aerobics. “Success stories are almost always preceded by failure,” says Syd Finkelstein, a management professor at Dartmouth’s Tuck School of Business. “That’s because the incumbent fails to see the changes around them. What’s missing in all of this today is the newer players, the newer thinkers.”

Failure is still acceptable. And we need to keep it that way. It’s well known that most new businesses fail and that successful entrepreneurs are the ones who keep trying until they get it right. Failure, in other words, is a vital part of American culture, because it makes you smarter and often you get another chance.

But failure is stigmatized in other countries with less of an entrepreneurial culture. That could happen here, too, if we keep spending billions to rescue people who make billion-dollar mistakes. If risk is going to come with rewards, it needs to come with consequences, too.